The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Thursday, November 22, 2012

Speaking to the parliamentary commission on banking standards, the Bank of England's Paul Tucker observed that splitting retail and investment banking won't make the system safer.

His reason for making this statement is that he thinks that investment banks are fully capable of blowing up the financial system.

Combine this with the historic fact that retail banks are fully capable of blowing themselves up (see: US Savings & Loan for example) and it is clear that pursuing regulations that would create a ring-fence or full separation is unproductive.

What is needed is reform that would actually make the financial system safer and financial crises far less likely to occur.

Regular readers know that there is only one reform that achieves this goal: bring transparency to all the opaque corners of the financial system.

That this works can be easily seen by the simple fact that

the parts of the financial system characterized by opacity, including complex rules/regulations and regulatory oversight, were the parts that ceased functioning and haven't resumed functioning since the start of the financial crisis.

the parts of the financial system characterized by transparency and market discipline have continued to function throughout the financial crisis.

Paul Tucker, the frontrunner to become the next governor of the Bank of England, has told MPs he does not want to see the full separation of retail and investment banks.

Speaking to a parliamentary committee on banking standards, Tucker warned that even if the separation of banks was forced by law, the economy would still be at risk of being "blown up" by non-retail banks and other financial institutions.

Tucker said: "The thing that has worried me most about this debate from the beginning ... is that people fall into thinking, 'if only we could make retail banking safe, the financial system will be safe', and frankly I think that is nonsense. I think the financial system and the economy will be capable of being blown up by vast wholesale dealers and non-banks."...

Please re-read Mr. Tucker's comments as he effectively explains why transparency is the solution that works rather than the combination of complex rules/regulation and regulatory oversight.

With transparency, nobody assumes that the financial system is or will be safe. Rather, all market participants know that they still have the obligation to independently assess the risk of each of their exposures and to not have a larger exposure than they can afford to lose given the risk.

That this occurs is not surprising as the FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Clarity, he said, was crucial to avoid banks lobbying the regulator."For the regulator to be effective, it has to be able to use judgment. But if judgment ends up simply as a negotiation between the regulator and the regulated bank, there's only one winner in that and I think that will be a very bad outcome."

While Mr. Tucker was talking about ring-fencing, I think his comment is applicable to the entire idea of substituting the combination of complex rules/regulations and regulatory oversight for transparency and market discipline.

The combination of complex rules/regulations and regulatory oversight is doomed to failure as it ultimately ends up as a negotiation between the regulator (who can be pressured by politicians) and the regulated banks that the regulated banks will win.

Ironically, transparency is all about bringing clarity and avoiding having banks lobbying the regulator.

Take ultra transparency for example. Under ultra transparency, banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details. This disclosure brings clarity to all market participants on the risks each bank is taking.

With ultra transparency it is no longer the regulator negotiating with the bank over the riskiness of the bank, but the regulator judging the riskiness of the bank using the analytical capabilities of the market (the regulator can ask other banks how risky they think each bank is for example).

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.